A Guide to Understanding Asset Location vs Asset Allocation

Asset location is a tax management strategy that involves placing your investments in the right types of accounts to help maximize tax efficiencies. The goal is to reduce your tax burden, increasing your net investment returns over time. 

Asset location can be particularly beneficial if you are in a higher tax bracket and/or have significant investments in taxable accounts.

Also, if you’re investing with a long-term horizon (when you need the assets or income from the assets), the compound effect of tax savings can be substantial. However, initial tax costs may be incurred when reshuffling assets to pursue an efficient location strategy.

Here are some examples of how you can use asset location strategies to your advantage:

• Contribute to Tax-Advantaged Accounts First: Prioritize your contributions to IRA, 401(k), or Roth accounts to take advantage of their current and future tax benefits.
• High Growth Investments in Tax-Deferred Accounts: Place investments expected to appreciate significantly, such as stocks, in tax-deferred accounts to defer taxes on your capital gains.
• Assets for Posterity in Taxable Accounts: Keep assets you plan to leave to heirs in taxable accounts to benefit from a stepped-up cost basis, minimizing capital gains taxes when the assets are distributed to heirs.
• Risky Investments in Taxable Accounts: More volatile investments have advantages in taxable accounts due to your ability to use tax loss harvesting to offset capital gains.
• Less Tax-Efficient Assets in Tax-Advantaged Accounts: Investments that generate significant interest, like corporate and government bonds, are better suited for tax-advantaged accounts to shield the income from taxes.
• Tax-Free Investments in Taxable Accounts: Investments like municipal bonds, usually tax-exempt, should be held in taxable accounts to take full advantage of their tax-free income.

Working with an experienced team of Austin retirement planners can help you craft an asset location strategy based on your specific needs, assets, and goals.

Asset allocation can be important as it determines the mix of various asset classes in your portfolio, such as stocks, bonds, cash alternatives, and other types of investments. This mix can balance risk and reward according to your goals, risk tolerance, and investment timeline. 

Your allocations may change as you age, especially as you retire. You might have a higher allocation to stocks to benefit from their growth potential in your early and mid-working years. Stocks, despite their volatility, offer the opportunity for higher returns, which is more suitable when you have a long amount of time to recover from potential market downturns.

As you approach retirement, the focus usually shifts towards preserving capital and generating retirement income. This could mean increasing the proportion of your portfolio's assets in fixed-income investments and more conservative equities. Fixed income is typically considered less risky and can provide a steady income stream, which becomes increasingly important as you enter retirement and start relying on your investments for your day-to-day living costs.

In addition to stocks and fixed-income investments, it may be appropriate to consider other assets, such as real estate or commodities, which can offer additional diversification benefits. Spreading your assets over multiple less correlated asset classes helps to manage your risk of large losses.

Tax efficiency, on the other hand, involves structuring investments in an attempt to minimize tax liabilities and maximize after-tax returns. This can be pursued through strategies such as placing high-yield investments in tax-advantaged accounts like IRAs or 401(k)s, taking advantage of tax-loss harvesting, or investing in more tax-efficient alternatives.

Here’s how tax efficiency plays into this:

• By holding common stocks in taxable accounts, you can sell underperforming investments to realize losses for tax purposes, then repurchase them after 30 days to maintain your preferred allocations.
• Investing in multiple tax lots allows for flexibility in realizing losses without liquidating entire positions.
• Holding investments for over a year can qualify them for long-term capital gains tax rates, typically lower than short-term rates.
• Avoid mutual funds with higher turnover rates. These funds can pass taxable capital gains to you, even in down years.

Together, asset allocation and tax efficiency can significantly improve your portfolio's performance. By carefully selecting a suitable mix of assets and employing tax-management investment strategies, you can pursue improved risk-adjusted returns, keep more of your hard-earned money, and possibly reach your financial goals more efficiently.

Not sure if your investments are allocated correctly? Consider partnering with a fiduciary investment advisor in Austin to analyze your current portfolio.

Charitable giving can also play a role in your tax strategy. While there are many sophisticated strategies to choose from, the following are five of the more common ones:

1. Donating Appreciated Assets: Consider donating stocks or other assets that have increased in value. This strategy allows donors to avoid paying capital gains taxes on the appreciation while qualifying for a tax deduction based on the asset's current value.
2. Bunching Donations: Accumulate charitable contributions that may occur over multiple years into one large donation. This approach can help you exceed the standard deduction threshold, making itemized deductions more beneficial for a particular tax year.
3. Donor-Advised Funds (DAFs): Contribute to a DAF and receive an immediate tax deduction. Then, over time, recommend grants from the fund to your chosen charities. This allows the retention of control for strategic, organized giving without establishing a private foundation.
4. Qualified Charitable Distributions (QCDs): For those over 70½, donating directly from an IRA to a charity can count towards the required minimum distribution. Donated amounts are not considered taxable distributions.
5. Charitable Trusts: Establish a charitable trust, such as a Charitable Remainder Trust (CRT) or Charitable Lead Trust (CLT), to provide income to the donor or other beneficiaries, with the remainder going to charity, usually upon the demise of both spouses. This can provide tax benefits and potentially increase the amounts distributed to heirs and charities. 

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Proper asset allocation is important for a more balanced approach to investing. Each strategy offers a unique approach for balancing risk and returns while aligning with your financial goals, investment horizons, and risk tolerance.

Strategic Asset Allocation is a long-term approach that sets target allocations for various asset classes and periodically rebalances the portfolio to these targets. It reflects your risk tolerance and investment horizon, staying relatively constant over time unless there's a significant change in your situation, financial goals, or risk profile.

Tactical Asset Allocation is an active strategy allowing short-term change from a strategic asset allocation to exploit current market opportunities or avoid potential downturns. Regular monitoring and adjustments to the portfolio based on short-term market outlooks are required.

Dynamic Asset Allocation adjusts your investment mix in response to changing market conditions and economic indicators, such as inflation or rising interest rates, in an attempt to protect the portfolio from downside risk or capitalize on growth opportunities.

Core-Satellite Asset Allocation involves using a 'core' portfolio, which is a large part of the invested assets, using a passive management strategy, and adding 'satellite' investments to seek higher returns actively. The core provides stability, while satellites aim to add alpha or excess returns.

Age-based (Lifecycle) Asset Allocation is tailored to your age and becomes more conservative as you approach retirement and your early, mid, and late retirement years. It typically involves a higher proportion of stocks if you are younger and gradually shifting towards more bonds and other types of fixed-income investments as you age.

As you can see, there are several ways to invest your assets that can help manage your risk and seek to improve your returns. This is where the power of working with an experienced wealth manager in Austin can benefit you.

Sector investing involves targeting specific sectors of the economy, seeking to capitalize on trends or developments within those areas. An example of strategies for diversification in sector investing could be focusing on the technology and healthcare sectors when technological advancements and healthcare innovations are positively impacting the profitability of companies.

Let’s say you allocate a portion of your portfolio to technology due to the increasing reliance on digital solutions, AI, and other software. You expect growth from companies developing new technologies, software, cloud computing, and cybersecurity solutions. 

Simultaneously, you could invest in the healthcare sector, anticipating growth from biotechnology firms, pharmaceutical companies, and other healthcare providers, especially when healthcare innovation is increasingly important for 78 million baby boomers and future generations. 

This approach allows you to spread risk across different sectors with the potential for growth due to evolving innovations.

Elections can introduce uncertainty into the markets, creating a more complex range of possible solutions. While the long-term market impact of elections might be limited, individual sectors can experience significant volatility based on election results, the impact of special interest groups, and subsequent changes in policies that impact your investments.

Key factors to watch:

• Tax policies, spending priorities, and regulatory changes can profoundly affect specific industries
• Staying informed and flexible allows you to adjust your sector investments in anticipation of or in response to political and economic shifts

To learn more about Beck Capital Management’s asset allocation and asset location services, we invite you to connect with us.